Sunday, December 11, 2011

Financial Repression

A couple weeks ago I posted this ( http://playwithmonopolymoney.blogspot.com/2011/11/banks-making-moneystill-through.html ), which discusses how the banks have been making money still through obtaining very cheap money through the Federal Reserve discount window, buying government bonds and taking the profit.  I explained how this is a major reason for the artificially low interest rates, mortgage rates, etc.  So that's the how.

If that's the how, "Financial Repression" and this post is the combination of the how and the why.

First, a definition...

A term that describes measures by which governments channel funds to themselves as a form of debt reduction. This concept was introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon. Financial repression can include such measures as directed lending to the government, caps on interest rates, regulation of capital movement between countries and a tighter association between government and banks.
Read more: http://www.investopedia.com/terms/f/financial-repression.asp#ixzz1gI5wfkvU


From wikipedia's definition...bold and underline mine
These measures allow governments to issue debt at lower interest rates than would otherwise be possible. A low nominal interest rate can help governments reduce debt servicing costs, while a high incidence of negative real interest rates liquidates or erodes the real value of government debt.[3] Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation, and it can be considered a form of taxation.[4]"
Definition link...



How I would translate...Financial Repression is a collection of ways that governments use to manipulate the costs of borrowing money for themselves, paying back the borrowed money, and directing money that they need toward themselves.

So why is this important?  Well, we all know that governments around the globe have run massive trade deficits and increased their debt by huge amounts.  Specifically in the U.S., there was all of the news about raising the debt ceiling over the summer.  Specifically in Europe they are going through a crisis again just like in 2010 with multiple countries having Debt to GDP ratios that are too high and unsustainable that could even collapse the Euro currency.

Here is a chart showing the Debt to GDP Ratio from a great summary of a great study done on Financial Repression.  The study focused on how governments reduced the amount of debt they carried after WWII.  As you can see, we are back to those levels.


Study of Financial Repression...very technical, long and boring, I haven't gone through it yet, but some good research is in there.
http://www.imf.org/external/np/seminars/eng/2011/res2/pdf/crbs.pdf

Summary article...I encourage you to read this

From the article link above...summary of the financial repression in the study
The specifics of financial repression took somewhat different forms in each of the advanced economies, but they shared four characteristics: 1) inflation; 2) governmental control of interest rates to guarantee negative real rates of return; 3) compulsory funding of government debt by financial institutions; and 4) capital controls. 

So let's get into how Financial Repression affects you...
#1 is inflation.  In order for the government have this work for them, they need inflation as I've said before.  Inflation makes the money they borrow cheaper, while making everything else more expensive for us when we purchase something.  

#2 is control of the interest rates to guarantee negative real rates of return...
When I took my finance classes, we were taught that whatever we invested in, we needed to focus on Real Rates of Return.  A Real Rate of Return = (Nominal Rate of Return - Inflation)...let's just ignore taxes and fees for now, although taxes and other fees would also be subtracted.

So let's say you can invest your money in a money market account and get a 3% a year return (interest) on that money.  This would be the Nominal Rate of Return (3%).  But if inflation is 3% a year, your Real Rate of Return is actually 0%.  

But right now, you probably couldn't get 3% on a money market account because the government has manipulated the bond markets through this Financial Repression #1 (capping interest rates very low).  So maybe you could get lucky and find 1% right now.  Well inflation right now is say 4% (I believe it to be much higher).  So your real rate of return right now if you leave your money invested in a money market account is -3%.  So you are thinking that you're actually making money, 1% by keeping your money in the money market account, but really, the government is inflating the currency and taking 4% of your money in the future when you buy something with that money, so you're left with losing 3%.  This is how the countries paid back the debt they incurred from WWII through the bond market.

Some countries had higher inflation, some had lower, but it just took more or less time to pay of the debts.  I believe the United States officially paid of WWII under Bill Clinton in the 1990's (so 50 years).  Not every year were there negative real rates of return from bonds, but the study showed quite a few.  

So one would hopefully wonder why anyone would invest in treasury bonds at such low interest rates (.12% for a 1 yr T-Bill) and inflation around 3.5% (officially)?


Well, most people usually don't, some investors do to get a "risk-free rate of return" and offset the risks of buying stocks right now.  But as I explained in my previous post, banks will.  They'll buy a ton, because they can borrow the money for even cheaper from the Federal Reserve.  They still get to book their spread as profit so they can keep making their money, and the government gets a guaranteed way to inflate the currency, and keep real rates of return negative (therefore helping to pay off their debt more cheaply). 

#3 Compulsory funding of government debt by financial institutions.
Here we're talking about either the government forcing mutual funds, teacher retirement accounts, pensions, and banks to purchase government bonds, or making it highly desirable to so.  Right now with the stock market and the world economy the way that it is, many are investing in government bonds for safety reasons,  even if it is a negative return, because the alternative is the riskiness of stocks with the potential to lose even more money.  Also, as mentioned earlier, the Federal Reserve is making it VERY attractive to borrow nearly free money to purchase government bonds.  As long as people have confidence that the government will be able to make their interest payments to keep interest rates low, this will continue.  When it doesn't, you can look at Greece, Ireland, Italy as examples.

One thing to keep an eye on is the mandatory purchase of government bonds as "safe assets".  Most likely you see this in teacher retirement accounts, pensions, etc where there is more concern about loss of wealth vs. the preservation of wealth.  If you see that happening all over, you'll know for sure that there are no longer the number of buyers the government needs to continue funding their massive spending, so either interest rates would have to rise (which is undesirable for governments to owe more on their interest), or they would have to force the purchase of bonds by other parties.  

I also think about WWII when there was advertisements to "Buy War Bonds".  It wasn't mandatory, but man would you have been un-patriotic if you didn't take a negative real rate of return on your "investment."










#4 Capital Controls.  
This is where the government puts controls on the flow of money in and out of the country and usually impacts the exchange rates.  I haven't seen too many examples of this recently, so we're not really to this stage yet.  If we were to this point, it's basically as if the government locks you into only investing within the country and the dollar.  I would think we'd have to be in pretty bad shape for this to happen, but you never know.  If the first three aren't working and people are sending their money to China, South America, etc at very high rates to escape the inflation, negative interest rates and near mandatory purchasing of government bonds, I could see it happening.  I would imagine they would also sell this as a "do it for your country" type thing first though.

So when you're saving your money, you'll want to have a real rate of return at 0% or better.  Otherwise, think of anything else as a donation to the government to pay down the debt and finance their excessive, and mostly idiotic spending.  And this is on top of the taxes you already pay.

Posted by at

No comments:

Post a Comment

Subscribe to: Post Comments (Atom)